Editor’s Note: The GOP tax reform bill changes the tax treatment of alimony (or spousal support) payments in one important way. Under the new rules, alimony is no longer deductible for the payor, and money received as alimony is no longer taxable income for the payee (having already been taxed as the payor’s income).
Essentially, the current (2017 and prior) rules allow divorced couples to shift taxable income from the payor to the payee. As a rule, alimony is a series of payments from the ex-spouse with higher income to the ex-spouse with lower income, and being able to shift the income to payee’s (presumably lower) tax bracket allows ex-spouses to lower the overall tax liability arising from the income being paid as alimony. The Following excerpt from The Tools & Techniques of Income Tax Planning explains the current tax treatment of alimony payments and how they can be “front loaded” to help lower overall tax liability.
For income tax purposes, alimony is deductible by the payor and includible in the gross income of the payee. However, simply labeling a payment as “alimony” does not mean it will be treated that way for tax purposes. Regardless of its designation or by court order or agreement between divorcing spouses, to be treated as alimony for tax purposes, the requirements of Code section 71(b) must be met. Alimony is any payment in cash if:
- The payment is made to or on behalf of a spouse under a divorce or separation decree.
- The divorce decree is silent as to whether the payment as is not includible in gross income or allowable as a deduction. This means that if the parties do not want a payment to be treated as alimony, language in the instrument that states that it is not includible or deductible will negate its tax status as alimony.
- The payee spouse and the payor spouse are not members of the same household at the time of payment.
- There is no liability to make this payment after the death of the payee spouse.
The requirement that alimony be paid in cash means it can only be made in cash, check or money order. Because of this limitation, a transfer of property or services to the payee spouse is not considered an alimony payment for tax purposes.
The significance of payment not being treated as alimony has profound tax consequences.
Example. Pursuant to divorce decree, Asher is to pay Ashley $5,000 a month for five years as alimony. In the event of Ashley’s death prior to the end of the term, Asher is obligated to continue to make those payments to Ashley’s estate for the remaining duration. Under those circumstances, the payments would not be treated as alimony because Asher’s obligation to make those payments continues following Ashley’s death. As a result, for none of the years (including the years in which Ashley was alive), Asher will not be entitled to a deduction and Ashley will not be required to include those payments in gross income. Instead, the payments will treated as a non-taxable “property settlement” with no tax consequences to either spouse.
Front Loading Alimony
Because alimony payments are deductible to the payor spouse, there is the temptation on his or her part to “front load” or make excessive payments in the early years of the alimony term to maximize deductions in those years. Then in later years, the payments are much less.
So as a negotiation tactic, it is possible that in exchange for a larger upfront deduction generated by a substantial initial payment, the payor spouse might agree to pay the payee spouse an overall larger amount of alimony. Conceptually, however, alimony is a mechanism to provide support to a spouse, which means the payments should be relatively level over the payment period. So this type of front loading appears to be more like a disguised property settlement than an alimony arrangement.
In order to curb potential abuse, Code section 71(f) essentially recharacterizes “excessive payments” as non-alimony. Generally, excessive payments are the amounts that are disproportionate to amounts that would have been paid as alimony in a relatively level flow.
Based on a formula beyond the scope of this blog, all payments (including excessive payments) made in the first two years of the payment period are treated the same way as any alimony payments (i.e., deduction for payor and income for payee). In the third year, however, the Code reverses the deduction the payor received for the year 1 and year 2 excessive payments by requiring he or she to include those payments in gross income.
Similarly, the Code reverses the inclusion by the payee spouse of excessive payment he or she included in gross income by allowing a deduction for such payments.
By doing so, the adjustment effectively converts the excessive payments into non-taxable non-deductible property settlement payments. The figure below provides an oversimplified table demonstrating the application of the front loading rules.